Making Sense of the Yield Curve

The Treasury yield curve is plunging further into inversion, the point at which long-term yields fall below short-term yields.

As shown in the LPL Chart of the Day, Yield Curve Plunges Further Into Inversion, points on the yield curve are nearing alarming levels. The spread between the 3-month and 10-year Treasury yields fell to -31 basis points (-0.31%), approaching the -50 basis points (-0.5%) threshold that has been predictive of recession within a year . At the same time, the spread between the 2-year and 10-year yields has dropped to 11 basis points (0.11%), closing in on inverted territory for the first time this cycle.

Treasury yields are pricing in an increasingly dire economic outlook, one still not warranted by recent data. The 10-year yield has dropped well below inflation growth. Gross domestic product (GDP) growth has been above-average so far this year, consumer spending has been solid, and U.S. corporate spreads have stayed surprisingly contained in this bout of market stress. Financial conditions are still historically loose, yet there are few signs of excess in the financial system.

“Even though the yield curve’s shape is sending ominous signals about the economy, we’re not convinced rates are an accurate reflection of domestic economic fundamentals,” said LPL Research Chief Investment Strategist John Lynch.

To be sure, it’s a curious time for global fixed income. There’s about $15 trillion in negative-yielding debt outstanding globally, an amount that has nearly doubled since the end of last year. Four G7 nations have sovereign debt with negative yields, and even lower rates could be ahead as central banks loosen policy to counter a slowing global economy. Trade uncertainty and global stock volatility has further fueled the rush into U.S. fixed income, as investors use Treasuries and other high-quality debt for income, safety, and liquidity.

The U.S. dollar is also strengthening, even after the Federal Reserve (Fed) cut rates and signaled flexibility to do more as needed. Global markets are forcing the Fed’s hand because the interest-rate differentials between the U.S. and other sovereign debt are still too wide. Recessions can be self-fulfilling prophecies of market sentiment, so we’re not minimizing the growing risk of one being born out of angst here. To us, though, the yield curve is sending a different signal than it has in the past: that U.S. monetary policy needs to better reflect market expectations before bond markets around the world can normalize.

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Please see the Midyear Outlook 2019: FUNDAMENTAL: How to Focus on What Really Matters in the Markets for additional description and disclosure.

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